(This commentary originally appeared on Real Money Pro at 7:44 a.m. ET today. Click here to learn about this dynamic market information service for active traders.)
* Let's start with Macy's!
* As expected, retail share price capitulation is now upon us.
"Buy at the sound of cannons?
For more than three years I have avoided -- with the exception of a losing JC Penney (JCP) long -- the retail space (indeed, I have been consistently net short consumer discretionary), suggesting that there will come a time when investors panic and retail stocks may offer value.
We are likely there, or at least close to being there now -- at a point in time when the maximum amount of pessimism may reside in investors' and trading thinking."
- Kass Diary, "I'm Looking for Some Magic From Macy's on the Long Side" (May 15, 2017)
Over the last five years changing channels of distribution have eviscerated traditional retailers' equity prices and devastated sales and profitability as retail overcapacity has been exposed.
This is a phenomenon I have covered extensively and summarized in a January 2017 column:
"The disintermediation of old-line, bricks-and-mortar retailers provides longer-term opportunities for those who buy the right companies at reasonable prices.
My conclusions are simple:
* Facebook (FB) , Alphabet (GOOGL) and Amazon (AMZN) win, but seem fairly priced. Other than the government, little can get in their way. Their market positions are bolstered further and their moats widened by artificial intelligence and machine learning. The only issues are their prospective rates of growth (discussed later) and valuation -- that is, whether the already broad knowledge and acceptance of their differential advantages are fully incorporated in share prices. For now, I believe this to be the case.
* The aging and lagging old-line retailers are now down but they may not be out, and a buying opportunity could lie ahead. The retailers' brick-and-mortar contingent is not the landline phone industry. There is a shift in distribution channels going on, but the Law of Large Numbers could become a problem for the winners (above) and may mitigate against their future rate of sales/profit growth. While the landline phone industry eroded, old-line brick-and-mortar retailers (terms I use interchangeably) are now a lot more like the cigarette industry. Yes, units are down modestly, but there are mountains of free cash flow well worth considering at or less than 6x EBITD. Indeed, it only could be a matter of time before private equity begins to step up and start picking. The large-cap retailers that could be among the vulnerable are Macy's (M) and Kohl's (KSS) ."
- Kass Diary, "How to Profit From Shifting Retail Distribution Channels"
Yesterday Macy's (M) lowered gross margin guidance and the shares of nearly every retailer tanked, some quite dramatically.
For some time I have been of the view that a capitulation in the retail sector would occur and that it could mark a long-term opportunity.
From my perch, we are now in the capitulation stage in which many retailer share prices finally are reaching price levels that provide a favorable reward-versus-risk ratio.
That said, just as cigarette companies issue a warning on the back of the cigarette package, I do as well:
Warning: If you worship at the altar of price momentum, do not read this analysis. Technicians will hate retailers' charts, which have been broken for one to two years and have not yet built a base. Technicians, as a group, do not like to buy falling knives. I, by contrast, look at upside/downside and probabilities in my analysis and stock selection. I also average into positions with the recognition that I can't call a bottom.
Nonetheless, today I will do a deeper dive on Macy's, which I plan to aggressively buy, to be followed by some other retail ideas to consider as longs over the weeks ahead.
A Macy's Parade May Lie Ahead
I am now a more aggressive buyer of M.
Macy's shares fell by 8% yesterday as the market responded poorly to the unusual (for it) analyst meeting that contained a downward margin guidance.
I believe at the current valuation that reward vs. risk has turned favorable and there are several possibilities that something positive may happen to the stock.
There are, quite simply, too many assets and too much cash flow. A leveraged buyout transaction also would include a high margin of safety. (The reasons why retail LBOs failed in the 1970s are simply not operative today).
Let me start by explaining why M's shares dropped by 8% on Tuesday on large volume.
Why and what happened?
First, what happened:
- During the meeting I had a real-time ticker for M's stock activated. Once the words "lower gross margin" were uttered, the stock declined 4%. This took place in seconds. Clearly, some very fast machines were listening to the webcast and not using limit orders. At least to this observer, this is quite terrifying. (The subject of machines and algos has been a constant diet in my Diary for months).
- Macy's did a "no no" in the meeting and the human analysts who were present were not happy. "We are maintaining guidance." Few believed it going into the meeting. HOWEVER, gross margins would be lower and asset sales (one-offs at best) would be higher. The natives were not happy campers. This triggered more (indiscriminate?) selling as the day progressed.
That is what happened. Now, why, and more importantly, why it should not matter over any investment horizon beyond the next few days.
Now, the why:
* More poor selling weather: The first quarter was killed by an awful February that backed up inventory and led to unplanned markdowns. May was much better, but June apparently has been awful with cold, wet weather east of Chicago.
* Foreign business is not there: This will obviously continue. As an example, Herald Square is the No. 4 tourist attraction in New York City. Foreign visitation to NYC is down for the first time in years and the Trump administration apparently would like to see it get worse. Foreigners spend a lot at Macy's in the gateway cities of Miami, NYC and San Francisco.
* Certain merchandise categories have become highly promotional: For example, Lord and Taylor is offering 15% off "nearly all" cosmetics for the "first time" and an extra 30% off "almost everything." I have seen a lot of retail promotions and this one is up there with those of 1974. These do not persist. In 1974, they were a buying signal.
A Leveraged Buyout or Other Takeover of Macy's May Be in the Cards
Why it should not matter at these prices on the stock:
As the company's CFO noted: "M is highly profitable (18% return on investment) and has a lot of cash flow ($2.7 billion on a 12-month trailing EBITD). Current interest cost on the debt is $400 million/year."
If Macy's were to be bought for only $30 a share in cash, $9 billion would be required at 10% interest to finance it. That would bring the interest bill to $1.3 billion. However, Macy's pays $460 million of after-tax dollars in dividends to its shareholders who obviously don't appreciate it. This probably equates to $700 million pre-tax.
Cutting the dividend to zero would finance almost 80% of the marginal debt cost of an LBO. If the LBO sponsor could borrow at 8%, the dividend would finance the deal.
Also, there appear to be significant opportunities to improve stock turn at the retailer. This is quite important. Working capital is singularly important in the retail industry. Macy's is become faster at fashion, having reduced certain procurement cycles significantly. Unit cost of inventory is still deflationary. (In the 1970s it became highly inflationary and working capital needs exploded upward, killing the model.)
Currently, Macy's sells at $6.7 billion in equity value with $5.8 billion of BOOK, net debt on its balance sheet. This can be easily partially repaid with free cash flow; there also are refinance opportunities.
A buyer may value it below $5.8 billion. But, even assuming a $5.8 billion value, M trades under 5x 12-month trailing EBITD, generating a pre-tax return of 20%.
In addition, M has significant real estate. Particularly ignored by analysts is parking lot acreage, which can be sublet to a Starbucks, Sonic or many others. Key urban stores are seeing some of their prime real estate (the first floor) monetized into high-rent boutiques. (This technique has been used by Galleries Lafayette in Paris for years to great success.) A joint venture with Brookfield will report progress on 50 stores inside of one year. Significant opportunity also seems obvious in Herald Square as NYC's core moves southwest to Hudson Yards and eventually Penn Station
More about 2017:
* Things should improve on the top line as the year progresses: Digital is growing in solid double digits (no numbers given) and becomes more important with time. The first half for apparel retailers is of limited import. M made a good case why its sales should improve and the consumer environment for the U.S. consumer is positive.
* The off-price strategy "Backstage" was explained well and the question of channel conflict well-addressed: Apparently, "Backstage" is being carved out of marginal square footage in underproductive stores and numbers given suggested a nice lift to the overall store.
* A note about media. The overall spend will decline. The company is a believer in digital with Alphabet (YouTube) and Facebook the clear winners. GOOGL and FB can measure the efficacy. Print is the big loser. My feeling is that TV will be flat to down as the company favors 15-second spots, which are 80% as effective as the 30-second variety.
* Gross margins should begin to look better in the second half. Sears Holdings SHLD looks to be on its last legs (finally) and several vendors are not shipping, according to people to whom I talked. The comparison is an easy one. There is always the weather and Amazon will gain share, but there is a lot of business left and Macy's clearly should survive, and over time, thrive.
Macy's stock currently yields 6.9%.
I doubt the $22 Macy's stock price will be a constant state in 2017.
Others -- such as activists and acquirers -- may come to the same conclusion.
